A Simple Premise

Warren Buffet won a $1,000,000 bet on this simple premise… 

Investing in the stock market is one of the most common ways of growing wealth over the long term. In today’s global economy, many investors have a challenging task deciding between investing in a diversified portfolio or a single index ETF like the S&P 500. This article will compare the risks and benefits of each approach and include historical data from 1999 to 2022 to provide a comprehensive understanding of the topic and why sage investors like Warren Buffet have embraced this time-tested approach.

Risks and Benefits of Diversified Portfolio: A diversified portfolio is a combination of different assets and investments, including stocks, bonds, commodities, real estate, and various other financial instruments. The benefits of a diversified portfolio are that it can reduce the risk of loss by spreading investments across different sectors and asset classes. If one sector performs poorly, the other investments in the portfolio may perform well and offset the loss. Additionally, a diversified portfolio can help investors achieve their financial goals, as different investments have different characteristics and perform differently in different economic conditions.

However, a diversified portfolio also has some potential risks. One risk is the difficulty in selecting the right investments. It can be challenging to choose investments that complement each other and perform well together. Another risk is the cost of managing a diversified portfolio, as the investor may have to pay fees to a financial advisor or brokerage. Lastly, a diversified portfolio requires a longer-term investment horizon and considerable patience, as the portfolio may experience periods of underperformance. 

Risks and Benefits of S&P 500 Index ETF: The S&P 500 Index ETF is a type of exchange-traded fund (ETF) that tracks the performance of the S&P 500 Index, a stock market index that represents the 500 largest publicly traded companies in the United States. The benefits of investing in an S&P 500 Index ETF are its simplicity and low cost. Unlike a diversified portfolio, an S&P 500 Index ETF requires no research or selection of individual stocks, and the ETF is managed by professionals, making it a convenient and low-cost investment option. Additionally, the S&P 500 Index has a long history of strong performance, making it an attractive investment option for many investors.

However, the S&P 500 Index ETF also has some risks. One risk is that the ETF is not diversified and is heavily concentrated in the US stock market. If the US stock market experiences a downturn, the ETF may suffer significant losses. Additionally, the S&P 500 Index is only representative of the largest publicly traded companies in the United States and may not accurately reflect the performance of smaller companies or international markets. Finally, the S&P 500 Index is market-weighted, meaning that the largest companies have the greatest impact on its performance.

Historical Data: To compare the performance of a diversified portfolio and the S&P 500 Index ETF, we can look at historical data from 1999 to 2022. During this period, the S&P 500 Index had an average annual return of 7.28%. However, the S&P 500 Index also experienced two significant bear markets, with losses of -37% in the dot-com bubble of 2000-2002 and -57% in the financial crisis of 2008-2009. While these represent dramatic changes in the short-term performance of the economy and markets, the overall long-term performance has been decidedly better than trying to predict the future. 

In comparison, a diversified portfolio with a mix of stocks, bonds, commodities, and real estate may have had a lower average annual return but may have also been less volatile. For example, a portfolio with a 60% allocation to stocks and 40% allocation to bonds may have had an average annual return of 6.1% during the same period. This portfolio would have experienced a loss of -22% in the dot-com bubble and a loss of -27% in the financial crisis, which was significantly lower than the losses experienced by the S&P 500.

As is the case with many investments, the long-term performance of a diversified portfolio and the S&P 500 Index ETF can vary. However, the S&P 500 Index has consistently outperformed a diversified portfolio over the long term. According to data from Morningstar, the S&P 500 Index has had an average annual return of 9.8% over the past 25 years (1997-2022), while a diversified 60/40 portfolio has had an average annual return of 7.2% over the same period.

It is important to note that past performance is not indicative of future results, and there is no guarantee that either a diversified portfolio or the S&P 500 Index ETF will perform similarly in the future. Ultimately, the choice between a diversified portfolio and the S&P 500 Index ETF will depend on your specific investment goals, risk tolerance, and financial situation. Before making any investment decisions, it is advisable to seek the advice of a financial professional.

In addition to a diversified portfolio and the S&P 500 Index ETF, there is another investment option to consider: market-linked certificates of deposit (MLCDs). Market-linked CDs are a type of savings instrument that offer the potential for returns linked to the performance of a specific market index, such as the S&P 500.

Investing in market-linked CDs provides investors with the opportunity to participate in the potential growth of the S&P 500 without risking their principal investment. This is because market-linked CDs are FDIC insured, just like traditional CDs, meaning that the principal investment is protected up to $250,000 per depositor, per institution.

Furthermore, in addition to the safety of the principal investment, market-linked CDs also offer a convenient way to invest in the S&P 500. Unlike traditional stock market investments, market-linked CDs have a fixed maturity date and offer liquidity via a secondary market, allowing investors to plan their investment strategy accordingly.

In conclusion, market-linked CDs represent the best way to invest in the S&P 500 for those seeking the potential for growth with no risk to their principal investment when held to maturity. Before investing in market-linked CDs, it is important to carefully consider the terms and conditions of the investment, including the maturity date, potential returns, and to consult a financial professional.

And now for the bet…   

Warren knew that investing in a simple S&P 500 index fund over a five-year timeframe would beat an actively managed portfolio and wanted to prove it! He solicited the investment community and found a willing professional investment manager to take the bet (poor choice) and at the end of the five years; Warren donated his million dollar winnings to a local women’s charity in Omaha Nebraska. Bravo Mr. Buffet. 

Sources:

• Morningstar. (2023). S&P 500 Index historical returns. Retrieved from https://www.morningstar.com/indexes/sp-500/historical-returns
• Morningstar. (2023). 60/40 portfolio historical returns. Retrieved from https://www.morningstar.com/funds/x/6040/historical-returns